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The Week Ahead; Looking Forward at Backwardation...

"IT'S THE END OF THE WORLD AS WE KNOW IT... AND I FEEL FINE"

It's the End of the World As We Know It, R.E.M.


The  moments in history when our view of the world has changed suddenly and dramatically are so etched into conscience that they are recalled solely by date: September 11th, November 22nd, December 7th.

Markets are dynamic and constantly changing and sometimes that change is dramatic and can be recalled by a year: 1929, 2001 or 2008.  However, unlike moments in history where the gravity and significance of an event is immediately apparent, market events tend to distill more slowly until a collective consensus is reached that leads to a watershed move.

The last couple of weeks, domestic markets have begun to react to the stress that's been rocking Asian markets for months.  Now, there is evidence that there has been a shift in thinking about market risk going forward.  I've previously written about the scenario known as 'contango' where docile volatility expectations lead to an erosion in the price of volatility ETFs.  The volatility market has been in a general state of contango for well over a year (and arguably much longer).

http://tancockstradingblog.blogspot.com/2015/07/buying-volatility-to-hedge-against.html

Friday however, we saw evidence of the opposite effect known as 'backwardation.'  Backwardation occurs when the implied volatility of S&P options is more expensive in the front month than the rollover month.  Therefore, the VIX futures are sold high at the end of the current month and bought for a cheaper price for the subsequent month.  On Friday, the SPY closed the day mostly unchanged but volatility ETFs were higher on the day.. see the VXX, VIXY & UVXY.

I read this to mean that there is an expectation of more volatility in the days ahead especially if Chinese markets continue to deteriorate to the point where they will be viewed differently than they were just a few months ago from a historical perspective.

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